Keep Your Options Open

Keep Your Options Open

over 4 years ago4 mins

Mentioned in story

Last week’s attack on Saudi Arabia – which took out half its oil production capacity – has got us thinking about the options and futures used by oil investors to speculate and accumulate...

🕰️ Recap

  • In January, a rival’s potential takeover of Norweigian Airlines – which doesn’t lock in its oil price ahead of time – was grounded. > Read our story
  • In February, investors’ buying and selling of Under Armour options offered up clues about how much its quarterly results would move its stock. > Read our story
  • In August, Tencent entered discussions with French media giant Vivendi to buy a stake in Universal Music Group – with an option to buy even more. > Read our story
  • And last week, the price of oil futures rose by the most in a single day for 30 years after Saudi Arabian production was disrupted. > Read our story

🔗 Connecting The Dots

Futures and options are financial products that derive their value from the stocks, bonds, or commodities they’re linked to – hence their collective name, “derivatives”. They’re a popular tool among professional investors, but are important because they help the global economy function day to day.

Here’s how they work. For a small fee, an investor can purchase the right to buy or sell a specific asset at an agreed price at some point in the future. That’s called an option. But if the investor’s certain they’ll want to own the asset later on, they can buy a futures contract – locking in its price now, but with an obligation to pay up when the time comes. Sellers of options and futures, meanwhile, collect an upfront fee they can invest elsewhere – so if the option’s buyer never comes calling, they’ll have profited. And similarly, they’ll make money if the price of the asset on the expiry date has since fallen below the price in the futures contract.

Investors use options to hedge against swings in other investments’ values – if not simply to speculate on asset prices. But, as we said, they’re also used on the ground, at the coalface of the economy. Farmers, for instance, sell futures in order to lock in a sale price for their crops – helping them plan future investments. And several airlines, which of course need oil-based jet fuel, buy futures to confirm their costs, making it easier to decide how much to charge for a first-class seat from New York to Hong Kong.

Companies with these arrangements in place typically shrug off fluctuations in oil’s value, as it won’t affect their costs for months or years to come. But in extreme circumstances, like the Saudi Arabian attack, a “force majeure” clause within options and futures contracts may kick in. A clause like this abandons agreed-upon terms and exposes buyers to the prevailing market prices, scuppering even the best laid budget plans.

🥡 Takeaways

1. Beware the witching hourOn Friday – known as “quadruple witching” day – several contracts for US stock index futures, stock index options, stock options and stock futures expire. It therefore tends to be a day investors rebalance their portfolios, replacing expired derivatives with fresh ones ahead of the fourth quarter – which can lead to higher-than-normal asset price volatility. So a Finimizer suddenly inspired to explore the world of options and futures might do well to wait till next week – when things have settled back down a bit 😉

2. Eyes on October’s prizeOptions analysis by Goldman Sachs shows volatility tends to be 25% higher in October than other months, with the technology and healthcare sectors experiencing some of the biggest spikes. Goldman reckons that’s because these companies start reporting third-quarter earnings next month – and because investors are perhaps quicker to respond as they try to lock in their profits before the year ends.

🎯 Also On Our Radar

Last week, British retail bellwether Next reported an earnings update which showed its store-based full-price sales fell last quarter versus the same time a year ago. At the same time, UK regulators appeared concerned Sports Direct’s takeover of Footasylum could lead to higher prices in store – and asked for the retailers to propose a solution or risk having the acquisition blocked.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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